Tuesday, December 4, 2012

The debate in the US about how to deal with the "fiscal cliff" has produced a counterproposal by the Republicans on how to avert a crisis. The proposal is criticized by many because of its lack of details (see here, here, here and here). The way the proposal avoids dealing with the real issues and suggests solutions that do not impose a cost on anyone reminds me of some of the debates in Europe about finding a plan to deal with Greek government debt or the capitalization of Spanish banks. In all these cases you hear proposals that seem to generate resources without anyone having to pay for them. Republicans in the US want to raise revenues without increasing tax rates, cutting spending without really cutting it. And the Spanish government will bailout banks without imposing any cost on tax payers. In some cases these proposal have no logic in others there is some logic but a lot of wishful thinking that generates economic miracles.

It is remarkable that the public debate on these issues is not done with more clarity on the real trade offs that are unavoidable when looking for a solution. The fiscal cliff debate in the US cannot escape two set of trade offs:

The first tradeoff is an intertemporal one. The government needs to produce budgetary plans that are sustainable, which given current conditions means to find additional resources. But trying to find resources too fast (cutting spending and increasing taxes over a short period of time) will have a negative effect on growth and might make the adjustment more difficult. This is the problem faced by the US economy over the coming months. Some want to create the impression that the problem is one of exploding deficits but this is not the "real cliff", the issue is the automatic cuts in spending and increases in taxes that will happen without any policy change. So when a plan claims to have found a solution by producing a $2 Trillion reduction in the deficit, it is not addressing the real issue.

The second set of tradeoffs are the fundamental ones in managing a budget: there needs to be consistency between spending and revenues (over a reasonable horizon). Here is where the debate is even less coherent and more likely to produce plans that assume miracles. Here are some of the miracles that tend to be present in these plans:

1. We can find a way to dramatically improve the efficiency of the government and, as a result, generate a large amount of resources. Interesting idea but there needs to be a realistic plan that is based on feasible improvements in efficiency and not jus wishful thinking.

2. No need to raise tax rates, we just need to close loopholes. This arguments tends to work because we all assume that it is only others who benefit from the loopholes. It would be better to identify who is going to pay for this rather than talking about loopholes.

3. We do not need to raise tax rates, we will cut spending. This goes well with the argument of efficiency, especially among those with strong priors that governments do not produce any value. But when we start talking about cutting items like pensions or healthcare, we either admit that we are happy getting fewer of those services or we will simply have to pay for them ourselves. So there is no real gain here you still need to pay for healthcare, not with taxes but with an increase in your insurance premiums (unless you make, once again, the efficiency argument).

A real plan needs to include first a statement on what are the services that we want the government to provide with an understanding that reductions in those services can have real consequences on individuals welfare. And then we need clarity on who is going to pay for these services. Here we cannot anchor the debate on the status quo (as I argued in my previous post), but it has to be a broad society decision on what we consider to be a fair distribution of the bill across different population groups.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).